The Fed Blog

Wednesday, April 30, 2014

ECB President Mario Draghi’s pledge to do whatever it takes to defend the euro has worked like a charm to calm the Eurozone’s financial markets. Indeed, since he said so back in July 2012, the area’s bond yields have plunged and stock prices have soared, especially among the peripheral countries. However, now ECB officials are concerned that the euro is too strong and contributing to deflationary pressures. So they seem to be doing their best to talk the euro down by hinting that they are considering various measures to ease credit conditions further.

The problem is that while ECB officials are trying to find the accelerator, they are still pumping the brakes. They are doing so by requiring Eurozone banks to pass stress tests. So the banks are shoring up their capital and improving the quality of their loan portfolios. It’s not obvious that imposing negative interest rates on their reserve deposits at the ECB or implementing QE would cause the banks to lend more.

ECB officials seem to understand that, which is why Draghi has been dragging his feet about actually doing whatever it takes. Draghi seems to be especially loath to drug up the Eurozone with liquidity by implementing QE. He must be unimpressed by the effectiveness of the QE programs in both the US and Japan. While he is struggling to determine what to do next, the Eurozone’s latest money and credit data show ongoing weakness:

(1) Money growth slowing. The Eurozone’s monetary aggregates are growing at a slower pace. Indeed, M2 was up only 2.2% y/y during March, the lowest growth since December 2011. A year ago, the comparable growth rate was 4.2%. This deceleration coincides with a decline in the Eurozone's core CPI inflation rate from 1.5% to 0.7% over the same period.

(2) Bank loans falling. There was more bad news in March’s lending by Eurozone MFIs. The three-month change in loans outstanding was negative for the 20th consecutive month. The good news is that the decline was only €37.6 billion, the least negative reading since July 2012, when the yearly rate was slightly positive.

Tuesday, April 29, 2014

Forward earnings are at record highs for all three of the S&P market cap indexes. There are no other developed countries with forward earnings trending higher into record-high territory. Let's have a closer look:

(1) Indeed, the forward earnings of the Developed World ex-US MSCI is still below its 2011 high, though it has been recovering since mid-2013. That’s mostly because the plunge in the yen in response to Abenomics propelled the forward earnings of the Japan MSCI by 37.0% last year.

(2) So far, the recovery in the Eurozone hasn’t shown up in the forward earnings of the EMU MSCI. Despite solid rebounds in the Eurozone’s M-PMI since mid-2012 and a similar upturn in Germany’s Ifo Business Climate Index, the EMU’s forward earnings has been flat for the past year after falling from mid-2011 through early 2013.

(3) Even more puzzling is the UK, which has had stronger economic growth than the Eurozone over the past couple of years. Yet forward earnings, which have been declining since the second half of 2011, are still falling.

(4) As for emerging markets, they are neither emerging or submerging, according to the forward earnings of the EM MSCI. It’s been basically flat since 2011.

The bottom line is that the US is the fairest of them all based on my analysis of forward earnings around the world. The only problem is that the US isn’t the cheapest of them all. There is a bit of a valuation problem in the US stock market because many stocks are either fairly valued or overvalued. The current internal correction should correct this problem. While it is happening, the S&P 500 could churn sideways for a while before grinding higher to end 2014 at 2014.

Today's Morning Briefing: Earnings World. (1) Fully Invested Bears. (2) Barron’s has a tired bull on the cover. (3) Big Money poll finds more bulls than bears, but less bullishness. (4) Everyone hates bonds. We don’t, but we don’t love them either. (5) Contrarian indicators. (6) Is the market’s leadership change a sign of a top? (7) A brief review of the internal correction. (8) A brief review of forward earnings around the world shows USA is fairest of them all, but not cheapest. (More for subscribers.)

Monday, April 28, 2014

Previously, I’ve argued that as long as the forward earnings yield of the S&P 500 exceeds the corporate bond yield, buybacks are likely to continue. This is a variation of what I called the “Fed Stock Valuation Model (FSVM),” which I discovered buried in the Fed’s Monetary Policy Report of July 1997. It showed a close fit between the earnings yield and the 10-year Treasury bond yield from 1982 through 1997. That’s just about when the model stopped working as a useful investment tool. It did show that the S&P 500 was overvalued during the late 1990s. But it has been significantly undervalued ever since then according to the model, which never gave a sell signal in 2007 or 2008. (See the Wikipedia article on the Fed Model.)

The model has been more useful for explaining corporate financial behavior. The corporate finance yield spread between the S&P 500 forward earnings yield and Moody’s seasoned Aaa corporate bond yield has been positive since 2004 and is currently 237bps. When it is positive, company managements can get a better return on their cash by repurchasing their shares than by investing it in fixed-income securities.

Alternatively, their companies can benefit by borrowing the money to buy back some of the company shares. Last year, nonfinancial corporations’ net new issuance of bonds totaled a record $640 billion. Some of those proceeds funded buybacks. (Although the Aaa yield applies to only a handful of corporations, it is pre-tax. So it should still be a good proxy for corporate borrowing rates after taxes, in my opinion.)

The corporate finance version of the FSVM suggests that companies can also benefit by using their cash or borrowed money to fund M&A when the forward earnings yield of the combination exceeds the corporate bond yield.

Thursday, April 24, 2014

China’s flash M-PMI edged up to 48.3 this month from 48.0 last month. It’s been below 50 for the past three months, suggesting that manufacturing is slowing. That’s not a surprise given recent weak exports data. In addition, the PPI inflation rate on a y/y basis has been negative for the past 26 months through March, indicating excess capacity is also weighing on manufacturing. The property construction market is also showing some signs of deflation recently.

So far, the government’s response hasn’t been sufficient to boost growth. That may be because the government is trying to reduce some of the excesses that led to the building of too many factories and too many ghost cities.

By the way, China’s crude oil demand has been flat at a record high over the past nine months through March. That doesn’t bode well for the country’s economic growth either. It actually suggests that growth may be slowing even faster than suggested by GDP and production indicators.

Wednesday, April 23, 2014

I’ve previously made the case for a secular bull market in stocks on the premise that subpar economic growth in the US and around the world reduces the likelihood of a recession. That’s because slow growth is bound to keep a lid on inflation, which means that the major central banks are more likely to maintain their easy monetary policies. In the past, maturing economic expansions often ended when inflationary booms caused monetary policy to tighten. The boom was then followed by a bust.

That’s not happening this time. The 4/20 WSJ included an interesting article titled, “Sluggish Economic Recovery Proves Resilient.” It reviews the various possible explanations for why the current recovery “is proving to be one of the most lackluster in modern times.” Nevertheless, “[i]t also is shaping up as one of the most enduring.”

The Business Cycle Dating Committee of the National Bureau of Economic Research determines the length of economic expansions and contractions (table). The current economic expansion just matched the 58.4 months average length of the previous 11 expansions since World War II. So far, real GDP is up 11.0% since Q2-2009, the trough of the last recession. That’s the weakest recovery of the previous six. That’s mostly attributable to the subpar recovery in real personal consumption expenditures.

So why is the recovery so slow? The article notes that Republicans blame Democrats for burdening the economy with taxes, debt, and regulations. Democrats blame Republicans for not agreeing to more fiscal spending and for playing a game of chicken with the debt ceiling. Economists are also a disagreeable lot, with some saying that the financial crisis of 2008 is still weighing on the economy. Others see “secular stagnation.” Not mentioned in the article was income inequality, which has recently become one of the main explanations of progressive economists.

I tend to side with the conservatives. I’ve frequently marveled at the resilience of the US economy notwithstanding the meddling of the federal government. I also believe that powerful deflationary forces have been unleashed by the proliferation of globalization and technological innovations. They are keeping a lid on inflation, which lowers the likelihood of a recession caused by tight money conditions.

Meanwhile, there’s certainly no hint of a recession in the Index of Leading Economic Indicators, which rose in March to a new cyclical high, and the highest reading since December 2007. The Index of Coincident Economic Indicators has been in record-high territory since last summer, and rose to yet another new high last month.

Our Fundamental Stock Market Indicator (FSMI), which tends to track the ECRI index, jumped 7.7% over the past eight weeks to a new cyclical high that nearly matches the previous peak during 2007. That’s a good omen for the stock market, since our FSMI is even more highly correlated with the S&P 500.

Tuesday, April 22, 2014

So far this year, the SMidCaps have been trading around valuation multiples of 17-19, while the S&P 500 has been hovering around 15. That suggests that the bubble this time is in small stocks. Indeed, the forward P/E of the Russell 2000 universe of these stocks, at the end of March, was 24 for the composite, with the growth and value components at 30 and 20, respectively.

The Russell P/E is significantly higher than the S&P 600’s current reading of about 18 because it includes more stocks of companies that either have no earnings or are losing money. Yet investors are willing to pay high prices for them, expecting that they will eventually have great earnings. These great expectations more often than not end very badly once these companies actually start earning money. When they do so, it becomes obvious how dangerously overvalued these stocks are, especially if growth expectations turn more realistic and less fanciful.

By the way, while the forward P/E of the S&P 500 was 15.5 during March, the median forward P/E was 16.6. This indicates that the larger-cap stocks are more fairly valued in the S&P 500 than the smaller-cap ones in this universe of LargeCaps. Back during 1999, the reverse was true.

Today's Morning Briefing: Bubbles & Clouds. (1) Bubbles now and then. (2) Small stocks are more inflated than large ones. (3) Russell 2000 forward P/E at 24 thanks to lots of small companies with no earnings. (4) S&P 500 also has some high-priced industries. (5) Is the Cloud a bubble? (6) Defensive sectors are no bargains. (7) No national real estate bubble yet, but competition to make risky home loans is heating up. (8) European peripheral bonds rally like the worst is over. (9) Are ETFs the next weapon of mass financial destruction? (10) “Captain America” (-). (More for subscribers.)

Thursday, April 17, 2014

There aren’t too many upside economic surprises in the Eurozone. In fact, one needs a magnifying glass to see the economic recovery since last summer over there. The region’s industrial production edged up only 0.2% during February. It’s up just 1.8% y/y, and remains 3.1% below the most recent cyclical peak during August 2011. The recoveries in Germany and Spain are a bit easier to see, but they have been weighed down by ongoing weakness in France and Italy.

So why is the European Monetary Union MSCI stock price index up 53% from 2012’s low? It’s not because of the EMU MSCI forward earnings, which shows no recovery at all. Indeed, it remains on a slight downtrend, which started in mid-2011. So far, the EMU MSCI rally has been all about valuation.

The lesson is that we should never underestimate the ability of central banks to drive up stock prices by promising to do whatever it takes to avoid financial meltdowns, recessions, deflations, and plagues. That’s what ECB President Mario Draghi pledged in his July 26, 2012 speech. He seems to be reiterating that theme recently, as I noted yesterday. So are some of his colleagues. That might be enough to drive valuations still higher for the EMU MSCI, as long as the Ukraine crisis doesn’t trip up the Eurozone’s feeble recovery.

Today's Morning Briefing: The Big Thaw. (1) From the Big Chill to the Big Thaw. (2) Spring forward. (3) February's batch of upward revisions is a big surprise. (4) Retail sales and production at record highs. (5) Housing has some headwinds. (6) Magnifying glass needed to see Eurozone recovery. (7) No recovery in forward revenues and earnings of EMU MSCI. (8) Will Draghi continue to levitate valuations? (9) Production growth slowing in emerging economies. (10) Focus on overweight-rated S&P 500 IT. (More for subscribers.)

Wednesday, April 16, 2014

March data released yesterday showed an increase in the CPI inflation rate to 1.5% y/y from 1.1% the month before. It was led by food prices and rents. The former rose 0.4% m/m, and 1.7% y/y. The CPI rent of shelter component rose 0.3% m/m, and 2.7% y/y, the highest reading since March 2008. This is a very odd measure indeed. It accounts for 32% of the total CPI. It has two major subcomponents, namely tenant rent and owners’ equivalent rent (OER). The former, which reflects actual rent paid by actual renters and accounts for 7% of the CPI, rose 2.9%, and has been hovering around this rate for the past 10 months. The latter, accounting for 24% of the CPI, has increased from 2.2% six months ago to 2.6% during March.

OER is an imputed measure of the rent homeowners would have to be charged to rent the homes they own. I kid you not, though I’m sure you knew that already. Presumably, it is based on actual tenant rent. Nevertheless, the recent leap in the OER inflation rate obviously can’t be explained by a similar jump in tenant rent inflation.

This oddity is one reason why the Fed prefers to use the personal consumption expenditures deflator (PCED) as a better measure of consumer price inflation. Both rent components are in the PCED too. However, the overall weight of rent of shelter is only 15% of the PCED, with tenant rent at 4% and OER at 11%.

It’s not obvious to me why the Fed’s commitment to boost inflation is a good thing, especially if inflation is led by higher food prices and rents. I doubt that will stimulate economic activity by causing consumers to buy food and rent apartments before their prices go higher. On the contrary, the rising costs of these essentials reduce the purchasing power of consumers.

Tuesday, April 15, 2014

Of course, there are still investors who believe that higher valuation multiples are justified by historically low interest rates. However, I’m not in that camp. Multiples should be driven by expectations for earnings growth. Currently, historically low interest rates reflect subpar economic growth with rising risks of deflation.

That’s not a wonderful scenario for revenues growth, nor for earnings growth given that profit margins are at record highs. Yet S&P 500 industry analysts are expecting earnings growth over the short term (STEG over the next 12 months) and long term (LTEG over the next five years) of around 10%. That seems a bit high to us, especially for LTEG.

The ratio of the forward P/E of the S&P 500 to LTEG (a.k.a. the PEG ratio) was at 1.4 during the week of April 3. That’s not far below previous cyclical peaks, which have all been around 1.5 since 1995. Those peaks haven’t always been associated with the start of bear markets. However, the PEG ratio confirms that stocks aren’t cheap. They are pricing in relatively optimistic earnings growth.

Meanwhile, the bond market seems to be discounting much slower nominal economic growth than the earnings growth rate in the stock market. I view the 10-year Treasury bond yield as the fixed-income market’s assessment of current nominal GDP growth on a y/y basis. The latter rose 4.1% during Q4-2013. Yet the yield is currently around 2.65%. Again, it seems as though historically low yields should justify higher P/Es, but the message from the bond market isn’t upbeat about the prospects for higher nominal growth.

Monday, April 14, 2014

The news out of China was mostly bad last week. On Wednesday, we learned that the country’s exports, on a seasonally adjusted basis, rose 11.0% m/m during March, recovering less than half of February's 24.2% plunge. Imports dropped for the second consecutive month by a total of 18.7% to the lowest reading since April 2012.

While the CPI edged up to 2.4% y/y during March, the PPI continued to deflate with a drop of 2.3% y/y, the 25th month of such negative readings. Our
new publicationChina Inflation & Deflation shows that PPI deflation is widespread, confirming that there is relatively weak demand and plenty of excess industrial capacity in China.

On Friday, the Chinese government failed to sell about a quarter of a one-year bond offering. This “bond failure” was attributed to the unwillingness of the finance ministry to offer a higher yield to attract buyers.

On Thursday, following the release of the disappointing trade figures, Premier Li Keqiang said, “We will not resort to short-term stimulus policies just because of temporary economic fluctuations and we will pay more attention to sound development in the medium to long run.” He also said that the government’s target of "about" 7.5% GDP growth this year was flexible, and Beijing would not act to pump up growth as long as “there is fairly sufficient employment and no major fluctuations.”

Thursday, April 10, 2014

Is “lowflation” good or bad for stocks? In her speech last week, IMF Managing Director Christine Lagarde warned that inflation might be too low: “There is the emerging risk of what I call ‘lowflation,’ particularly in the Euro Area. A potentially prolonged period of low inflation can suppress demand and output--and suppress growth and jobs.” That sounds like a bearish environment for stocks. However, she then said that the solution is “[m]ore monetary easing, including unconventional measures…” Her advice was directed particularly at the ECB.

More ultra-easy monetary policies from the world’s major central banks in response to lowflation is bullish for assets in general and stocks in particular. In the past, there has been an inverse correlation between inflation, as measured by the core personal consumption expenditures deflator (PCED), and the forward P/E of the S&P 500. Most recently, the P/E rose from a low of 10.4 during August 2011 to 15.5 last month. Over that same period, the PCED inflation rate, on a y/y basis, fell from 1.6% to 1.1%.

An even better fit is between the P/E and the Misery Index, which is the sum of the inflation rate and the unemployment rate. Since the 2011 low in the P/E, the Misery Index has declined from 10.6% to 7.8%.

Lowflation is bullish because the Fed is much less likely to tighten as long as it persists. While Fed Chair Janet Yellen caused a stir recently by suggesting that the FOMC might start raising interest rates six months after QE is terminated at the end of this year, she also said it depends on whether inflation rebounds back to 2%.

Wednesday, April 9, 2014

The Nasdaq peaked on March 5. Let’s use that as the date on which the S&P 500 started what I still view as an internal correction, with money coming out of high-priced growth stocks and going into lower-priced value stocks. Let’s have a closer look:

(1) Information Technology. For starters, let’s focus on the Information Technology sector. As you can see in our Performance Derby table, since March 5 through March 7, it is down 2.8%. Now let’s sort the performance for selected industries in the sector from worst to best and show the forward P/E at the end of March: Internet Software & Services (-13.4%, 23.9), Application Software (-12.2, 36.1), Data Processing & Outsourced Services (-6.6, 19.7), Communications Equipment (1.9, 12.9), Systems Software (2.1, 13.5), Semiconductors (2.9, 14.9), and Semiconductor Equipment (4.8, 15.2).

I’m seeing a pattern here of losses in the shares of industries with relatively high P/Es and gains in those with relatively low P/Es.

Today's Morning Briefing: IMF’s Bullish Outlook. (1) A happier outlook for all but Japan. (2) Eurozone’s recovery remains lackluster. (3) US growth set to increase. (4) Upbeat on India. Not so much on Brazil. (5) An economic scenario that will keep secular bull charging. (6) Three risks to worry about: Deflation, EM crisis, and Geopolitics. (7) CRB commodity index and world forward revenues are looking up. (8) Examining the internal corrections in S&P 500 IT and Healthcare sectors. (More for subscribers.)

Tuesday, April 8, 2014

While the yen and the Nikkei are marking time waiting for more stimulus from the BOJ, Eurozone bond yields are plunging, especially in the peripheral countries, on expectations that the ECB soon will counter mounting deflationary forces by providing another round of monetary stimulus. The Italian and Spanish 10-year government bond yields are down by about 100bps since late last year to 3.2%. The French yield is down to 2.0%, while the German yield is at 1.5%. Even the Greek bond yield is down to 6.1%.

In his 4/3 press conference, ECB President Mario Draghi raised those easing expectations when he said: “The Governing Council is unanimous in its commitment to using also unconventional instruments within its mandate in order to cope effectively with risks of a too prolonged period of low inflation.” During the Q&A session, he explained: “So this statement says that all instruments that fall within the mandate, including QE, are intended to be part of this statement. During the discussion we had today, there was indeed a discussion of QE. It was not neglected in the course of what was actually a very rich and ample discussion.”

On Friday, Reuters reported that according to The Frankfurter Allgemeine Zeitung, the ECB “has modelled the economic effects of buying 1 trillion euros” as part of a QE program, estimating that it would add 0.2-0.8 percentage points to inflation. Frankly, that seems like very little bang for some much additional liquidity. Furthermore, it was also reported that “an unnamed senior central banker was extremely concerned about possible market distortions that could result from such an intervention, and feared such purchases could create a bubble in the corporate bond market.” There certainly seems to be a bubble in peripheral bonds already.

Monday, April 7, 2014

I try not to drown in the deluge of data that comes out with every employment report. To stay focused on the key numbers, I calculate the product of aggregate weekly hours worked times average hourly earnings in private industry. The former rose 0.7%, while the latter was flat last month. The resulting YRI Earned Income Proxy, which is highly correlated with private wages and salaries, jumped 0.7% during March. This augurs well for a big rebound in retail sales during the spring.

There was other good news. Payroll employment during the first two months of the year was revised up by 37,000, boosting the January-March gain to 533,000. The household employment measure rose 1.156 million over the same period, with full-time employment accounting for 63% of the increase. Keep in mind that the payroll measure counts jobs, while the household measure counts workers, who may have more than one job.

Thursday, April 3, 2014

The Chinese government is scrambling to boost economic growth by implementing a new central plan that will continue to urbanize the country. The official March M-PMI report remained relatively weak, though the overall index edged up to 50.3 from 50.2 in February. While the output index was at 52.7, the orders index was only 50.6. More disturbing is that the employment index (at 48.3) remained under 50.0 for the 22nd consecutive month. The country’s flash M-PMI was only 48.1 last month.

Wednesday, April 2, 2014

I have been predicting that the stock market would respond positively to rebounding economic indicators even though everyone knows that some of that strength is simply weather related rather than a sign of economic strength. Nevertheless, investors might have been concerned that the winter’s weak numbers might have been fundamentally weak rather than just depressed by the big chill.

So once again, a relief rally is driving stock prices higher. We saw that yesterday in response to the solid M-PMI and auto sales for March:

(1) M-PMI. The M-PMI climbed to 53.7, up from 53.2 in February. The gain was led by production (55.9) and new orders (55.1). The spring in the March manufacturing survey was confirmed by a similar rebound in the average of the six regional surveys that I track.

(2) Auto sales. Sales delayed by the bad winter weather coupled with increased incentives fueled a jump in March vehicle sales to 16.4 million units (saar), up from 15.3 million units in February. As a result, Q1’s average rate of 15.7 million units was just about equal to that of the last two quarters of 2013.

Today's Morning Briefing: Do Earnings Matter? (1) Q1 earnings expectations slashed. (2) Expected growth for S&P 500 earnings just 0.9% y/y. (3) So why are stocks back at record highs? (4) The end of the never-ending winter. (5) Double-digit earnings growth expected to make a comeback soon. (6) Forward earnings matter, and they are at record highs. (7) A relief rally celebrating better weather. (8) Regional and national M-PMIs rebounded in March. (9) So did car sales, but Q1 average was no higher than H2-2013 average. (10) Q1 Performance Derby. (11) Health Care P/E rebounded after HillaryCare, and doing so again despite ObamaCare. (12) Focus on market-weight-rated S&P 500 Health Care. (More for subscribers.)

Tuesday, April 1, 2014

There’s a good chance that the Japanese government is about to repeat a rookie mistake that was made back in April 1997, when the sales tax was raised from 3% to 5%. Consumer spending took a dive. Today, the government is doing it again, raising the tax from 5% to 8%.

That tax hike will hit just as Abenomics seems to be losing its mojo. Household spending dropped 2.5% y/y during February. Housing starts are down 12.9% over the past two months through February. Industrial production, which rose 10.3% y/y through January--partly on expectations that consumer spending might soar before the tax hike--dropped 2.3% m/m in February.

On April 4 last year, the BOJ announced aplan to double the monetary base within two years: “Under this guideline, the monetary base--whose amount outstanding was 138 trillion yen at end-2012--is expected to reach 200 trillion yen at end-2013 and 270 trillion yen at end-2014.” In February, it was 210 trillion yen, suggesting a 29% increase by the end of the year. Yet, as I’ve been noting recently, there are mounting signs that this monetary “arrow” of Abenomics has been missing its mark.

Today's Morning Briefing: Rookie Mistakes. (1) The bears made a rookie mistake. (2) QE has been tapered, not terminated. (3) Thanks again, Fairy Godmother! (4) Yellen and Reagan. (5) Unemployment gets personal for Yellen. (6) Did Yellen make a mistake at her first press conference? (7) Putting more weight on wage inflation. (8) Draghi’s problem is strong euro and low inflation. (9) ECB has to stop the talk, and walk the walk. (10) Repeating a rookie mistake in Japan. (11) Bad loans in China weigh on Financials sector. (12) A Tech bubble made in China. (More for subscribers.)

Search

Translate

ABOUT: Dr. Ed Yardeni is the President and Chief Investment Strategist of Yardeni Research, Inc., a provider of independent investment strategy and economics research. This blog highlights excerpts from our research service, which is designed for investment and business professionals.

CHART ROOMS

Please see our new and improved website which works great as an app too!